15 December 2017

Blockchain technology: Smart contracts explained

by Daniel Evans

The first piece of this short series explained cryptocurrencies, a little of how they work, and why they are so potentially empowering for free trade.

Currencies are just the beginning. Smart contracts and tokens will transform every aspect of trade and every instrument we use to facilitate it.

Smart contracts are like “if this then that” blockchain-based programs. You can write them so that if certain conditions are met, they automatically deliver a certain result. Nick Szabo (a man widely and credibly speculated to be Satoshi Nakamoto, the mysterious creator of Bitcoin) compared them to vending machines. You put a coin in the machine, press a button, and it delivers a result.

The most popular blockchain for smart contracts is Ethereum. Bitcoin was created as a payment network but Ethereum is like a giant decentralised computer. Its native cryptocurrency, “ether”, is a way to pay for processing time.

Some of the many other uses for smart contracts I’ve seen (some functional, some under development) include flight delay insurance, royalty payments for musicians, supply chain management, and even electronic car keys.

Smart contracts can also be used to create “tokens”.

To help understand, consider paper. You can buy and sell paper itself but if you treat it in certain ways then it becomes more interesting. You can turn paper into bank notes, books, or origami cranes. Something similar can be said for cryptocurrencies and smart contracts.

Tokens can be used for something as simple as a new cryptocurrency or something much more sophisticated. There are tokens which help decentralised file storage, privacy and patient control over sharing of medical records, “land” in virtual reality, guns in augmented reality computer games, or issuing financial instruments such as shares or bonds.

It should be a bit clearer now why cryptocurrencies are just the beginning when it comes to blockchains.

It may be some time, however, before we see the same level of decentralisation for financial securities. In the meantime there are still plenty of benefits to issuing securities on a blockchain. The creation of Bitcoin was partly a response to the 2008 financial crisis. The crisis wasn’t just significant for the currency-related responses (devaluation, bailing out banks, quantitative easing, taking from some to give to others) but also for bank failures themselves – the failure of critical, opaque, central points in our financial system.

Counterparty risk for securities trading can be greatly reduced with blockchains. You can combine many different functions (e.g. trading, clearing, settlement) into one transparent, immutable, decentralised technology and eliminate the need to trust more people to do a good job.

All of this and more is possible because of smart contracts and tokens.

This is the second of four short pieces explaining blockchain technology: cryptocurrencies explained; smart contracts explained; the role of regulators; rethinking property rights.

Daniel Evans

Daniel Evans is part of the team that started the Gibraltar Stock Exchange (GSX). He has owned bitcoins since 2010. The GSX is starting a crypto-asset market, the Gibraltar Blockchain Exchange. This article does not necessarily reflect the opinion of the Gibraltar Stock Exchange.